The stock market's latest pullback has some bulls on edge. After
an uninterrupted rally that started in November, the recent
pullback deleted 5% of gains and has thus far become the largest
correction since then.
My article "
Are Technicals Signaling a Storm Ahead
" already suggest a heightened sense of insecurity, and now I'm
watching a few key things concerning market sentiment (or mood of
the market) to keep us ahead of a deeper correction.
How to Use Sentiment Data
If I told you that a certain penny stock trading on the Nasdaq
(NYSEARCA:QQQ) hit record highs in May 2013, you likely would
dismiss it and say, "So what?" I most certainly would, mainly
because we have no clue if the standalone data is meaningful
information or not.
But if I told you that the amount of aggregate trading in penny
stocks just surpassed the previous peak levels that occurred in
February 2000 (coinciding with the Nasdaq's all-time price high),
we start to get a better idea of how the data can be helpful.
By itself, it may not be meaningful, but when compared to the same
data throughout history, it can be eye-opening, especially in
recognizing extremities. This is how a lot of sentiment analysis
works. The Nasdaq penny stock action is really put in perspective
when it is revealed that typically penny stock volume peaks at
market peaks and bottoms at market bottoms.
The below table and simple chart of the Nasdaq (NYSEARCA:QID)
captures the penny stock volume at recent major market peaks and
troughs (in red). A pickup in penny stock action on the Nasdaq
(NYSEARCA:PSQ) may be warning of a topping market as speculators
again go to extremes chasing penny stocks and a rising market's
The Bigger Picture
This is just one sentiment example and may just be coincidental and
not proving anything, which is why I have looked at over 25 other
sentiment indicators to get a better idea of current levels
compared to historical market peaks and troughs.
An example of that report is shown below with a key takeaway that
almost all sentiment indicators have reached or were again very
near their all-time high bullish levels recently. This data
overwhelmingly shows that the market (NYSEARCA:VTI) was likely much
closer to a major long-term selling opportunity than a major buying
Three of the many popular adviser surveys are shown below. Two of
the three recently reached their all-time high bullish levels and
the third was in the upper levels of its historical past. By
comparing the levels associated with market tops to levels
associated with the 2008-2009 low, it is clear that there is a
distinguishable difference between bullishness during market tops
and bearishness during market bottoms.
Advisors in these surveys become most bullish near market tops and
most bearish near market bottoms, exactly opposite of what they
My firm summarized our findings by saying, "Sentiment can be a very
powerful driver of share prices (NYSEARCA:IWM) as the herding
mentality of investors can takeover near market tops and bottoms.
Being able to recognize such times in history can help you stay
clear of irrational investment decisions."
Abenomics and Sentiment
Japan's recent market rise was accompanied by record smashing
bullish sentiment as measured by the Tokyo Stock Exchange's margin
and commitment of traders (
) data. For only the second time in history, Japanese margin
traders as a whole actually carried net positive positions
(profitable). Moreover, large speculators were the net longest they
have ever been since at least the early 1990s. Typically these
traders are considered the "dumb money" because over the long run,
they are usually on the wrong side of the trade. There was no doubt
that this would not last, and it didn't.
We knew sentiment was ripe for a major reversal in the Japanese
stock market's (NYSEARCA:EWJ) uptrend and that a reversal in the
positions of the long margin traders and speculators would lead to
a deep Japan (NYSEARCA:DXJ) decline; we just needed to wait for
price to confirm the trend change before we could capitalize on the
price and thus sentiment reversal.On May 22, that trend reversal
occurred and on May 29, we advised going short the Japanese market
by buying the
ProShares UltraShortMSCI Japan ETF
(NYSEARCA:EWV). We also recommended put options. EWV was at $21.17
then and rose above $23 within a week in a great example of how a
shift in sentiment can move the markets very quickly.
What to Expect
With sentiment in the US markets having already reached peak
bullishness, it is likely the majority of buyers have now already
bought in. This means the risk is now likely to the downside. With
the recent pullback in price, we may finally be seeing the
technical picture breakdown. Next to follow would be overall
sentiment deterioration that would drive prices lower.
Once two key price levels I am watching are breached to the
downside, it is likely that many bulls will start to reverse their
positions and switch their overall sentiment to a more neutral or
bearish stance, just as the Japanese market is doing now.
Editor's note: This story by
originally appeared on
To read more from ETFguide, see:
How to Figure Out Your ETF Costs
Are Technical Indicators Signaling a Storm
Don't Get Duped by Gamed Corporate Earnings